How to link strategy to day-to-day decisions
Too many small companies develop a strategic vision and direction, but fail to do what it takes to make it come alive in the business. Strategy creates value only when you directly link it to the day-to-day operational decisions you make.
To do that, you need to view your business through the prism of the seven strategic value drivers that create value for any business:
- Sales growth rate
- Competitive advantage period
- Increases in working capital
- Fixed capital
- Cost of capital
- Tax rate
Let’s look at each of our seven drivers in terms of what we can observe and influence.
Sales growth is derived from three main areas: macroeconomic growth, market growth and changes in market share.
With a current macroeconomic growth forecast for the UK of 0.5% in the second quarter this year (0.3% in Q1), we have the overall picture for the UK in 2013 in a range between 1.6% and 2%.
Now let’s look at your market and your competitive strength within it. Recent trends are a good indication of your relative competitiveness, but consider market maturity and competitor action as well as you own sales and marketing initiatives to decide what growth is achievable.
Current profitability can be a good place to start, but assessing your market’s attractiveness by using Porter’s Five Forces will identify the longer-term profitability you can expect to achieve in a market:
- buyer (customer) bargaining power
- threat of entrants
- rivalry between existing competitors
- bargaining power of suppliers.
While each of Porter’s forces are in themselves multifaceted, form an opinion of each from a theoretical standpoint and from observable behaviour in your market to decide whether your company’s position relative to the force is favourable (+1), neutral (0) or unfavourable (-1). An overall positive score would suggest a profit margin of 5-10% or more. A negative score significantly reduces the expected margin.
Having arrived at a growth rate and profit margin for your business model, it is important to assess their validity into the future. You need to allow for the law of diminishing returns, which I prefer to think about as how long can I maintain the competitive advantage period my business currently enjoys? One year? Three years? Probably not indefinitely.
When considering working capital, refer back to the relative strengths of your customers and suppliers, as this will have a strong bearing on how payment terms affect working capital. If you pay suppliers significantly before your customers pay you, one or other of these forces is likely to be unfavourable. The other element of working capital is the extent of stock that needs to be held. Also consider the impact of extended sales cycles and other pre-sales activities.
The value of your capital assets is directly linked to their utilisation. In economic terms, you don’t want to be forced to operate below the optimum economic scale for your business by lack of demand for product. Equally, you must recognise where an operation has become uncompetitive due to lack of capital investment.
Decisions to increase fixed capital tend to be directly linked to growth ambitions. Where investment is significant, it will have the effect of pushing positive cash-flows further into the future.
Having projected your business model into the future, flexed it using the growth %, profit margin % and advantage period and allowed for working capital and likely fixed capital investments, you will have developed a steam of future cash-flows, which have been subject to rigorous strategic and operational analysis.
Cost of capital
You now need to know the cost of capital – effectively the discount rate you will use to calculate the net present value of the future cash-flows contained in your business model.
The cost of capital equates to the weighted average cost of capital, which you arrive at as follows:
(cost of equity x proportion of total capital) + cost of debt
It’s worth noting that debt benefits from a tax shield so of course you need to take into account the tax rate prevailing at the time. While the tax shield means that debt is generally cheaper than equity, debt tends to have the effect of lowering the cost of capital.
So, to sum up. Having examined your business through each of the seven strategic value drivers, you will arrive at a financial valuation that is underpinned by theory and practice. This can then be the basis for making the day-to-day operational decisions that will help you grow and achieve your strategic goals.